Are Bonds Setting a Trap?

The easiest way for U.S. bond markets to entice investors to abandon their obsession with a flattening yield curve—and whether it’ll soon invert—always was to steepen it. The spreads between 5y/10y and two-year yields have widened to 17bp and 30bp, respectively, about 10bp wider than at the end of August. More importantly, this move has occurred as a result of higher mid-to-long term yields. A few basis points don’t make a trend, but the combination of U.S. 5y and 10y bond yields pushing above 3% introduces a number of erstwhile dormant narratives into the mix. Perhaps the mythical neutral, or terminal, rate is higher than the Fed and markets think? Fed Chair Jerome Powell admitted recently that the FOMC probably doesn’t know where this rate is. This argument makes little sense in the context of the dots, which seem to imply that a policy rate of a bit over 3% in 12-to-18 months time is deemed restrictive. But it makes sense if this signal is no longer relevant for markets. The always optimistic David Zervos, the Chief Strategist for Jeffries, detects a shift at the Fed. “The most important takeaway here is that the probability of an aggressive late-cycle curve inversion has plummeted. (...) Maybe Jay goes there if we start ripping toward 3500 in spoos, but it won’t be because of the inflation or growth data.”